In the global economy, the past few
months have been as bizarre as anything that could be imagined. And nowhere
is this more evident at the moment than in Europe, where the crazy and
unsynchronized tango between financial markets and governments now threatens
the lives of ordinary citizens.
Consider the fear that is now supposedly spooking the markets, that of
the possibility of sovereign default. At the frontline is Greece, the
country that is being asked to impose an unbelievably severe austerity
package that is bound to cause employment and incomes to spiral downwards,
in return for a supposed ''improvement'' in state finance, which are nonetheless
projected to be in parlous condition for years to come.
Just behind Greece come the next line of countries under attack, currently
Spain and Portugal, and quite soon possibly the UK. Other governments
that have been implementing draconian budget cuts already, like Ireland,
Estonia and Latvia, still find it hard (and getting harder) to borrow
money for new public debt.
Now, even countries that do not seem to be under pressure from financial
markets (like France) and those that cannot possibly be under pressure
because they have large current account surpluses (like Germany) are also
announcing budget cuts and moves to fiscal austerity.
The funny thing is that, the more the governments announce budget cuts
and other measures to squeeze out savings in the economy, the worse the
hit that their bond markets seem to take. Interest rate spreads have been
rising and signs of investor panic in sovereign debt markets spread just
as governments try to placate markets by bowing to their pressures to
cut government deficits. So, instead of being rewarded for good behaviour
by the financial markets, they are being further punished.
What exactly is going on? It is really a case of the stupidity of markets
being magnified by the apparently even greater stupidity of economic policy
makers, who seem to be undertaking knee-jerk responses to changes in market
sentiment, rather than engaging in strategies based on an appreciation
of actual macroeconomic processes. As a result, their actions serve to
generate precisely the opposite tendency from what was desired, thereby
causing further financial panic.
Consider the current situation. The global economy is recovering from
a major recession but the recovery is fragile, uneven and easily reversible.
It is fairly obvious–and indeed was universally recognized in the midst
of the financial crisis in 2008–that when private economic agents are
caught in a liquidity trap or in a deflationary spiral, governments must
increase their own spending and ease access to credit to keep the economy
going. If they also cut spending and tighten monetary policy, they will
worsen the downswing and possibly even cause a deep depression. In other
words, macroeconomic policy should be countercyclical, not procyclical.
The only way this can be avoided is if the economy concerned tries to
rely on global markets and increase its net exports, or if the attempt
at stabilization somehow makes the economy appear very attractive to foreign
investors who rush in to invest (which is typically very unlikely in a
stagnant or declining market). The dependence upon foreign markets is
why the IMF typically has advised this brutal combination of fiscal and
monetary tightening to countries in deficit, effectively bringing on even
sharper slumps in many of the countries that have taken their medicine.
But obviously, this is not something that all countries together can hope
to do. So if all countries expect that external markets will save them,
then all of them will sink together.
But that is precisely what all the economies in Europe are collectively
expecting. This has another predictable result, which is that the attempt
to reduce the fiscal deficit can become self-contradictory. Governments
cut their spending and impose austerity measures. This then reduces incomes
and employment immediately, and over time through the negative multiplier
effects. As a result, government tax revenues come down. This can even
lead to a worse fiscal deficit than before, as many countries have found
in the past. In fact, it is well known that since tax revenues go down
in a crisis or a recession, the fiscal deficit is bound to increase. Policies
that aggravate the slump will only make it worse.
Now consider how this plays out in interaction with private financial
markets. When private investors apparently decide that a country’s level
of government debt is ''too high'' or that it has current account or fiscal
imbalances that are ''too large'', the spread on interest on that government’s
debt rises. Bond yields rise as bond prices fall. The country finds new
borrowing more difficult and/or more expensive. The government then decides
that it has to cut back on spending in order to reduce the deficit. The
markets (or at least the financial media) applaud this decision. But then
the cutbacks cause more economic pain in terms of reduced incomes and
employment, which makes the growth prospects worse. So financial markets
respond by further increasing the spreads on government debt! And so on.
In fact, the prescription for austerity in these countries is bizarre
because it undermines the foundations for economic growth without which
they will never be able to repay existing debts.
This ridiculous drama can go on for a while, and the only thing that can
stop it is decisive government action. But such is the control of the
financial markets that they seem to have come to completely dominate public
policy discussion, at least in Europe where these basic economic processes
seem to have been forgotten. We have got to the point where even the US
government is concerned at how this completely slavish and illogical response
will threaten global economic recovery.
What is even more amazing is that surplus countries in Europe like Germany
are also opting for fiscal austerity measures, even though these will
definitely rebound adversely on growth in the entire region. As long as
this peculiar combination of mercantilist expectation of exports saving
all economies and emphasis on fiscal austerity in the midst of the downswing
persists, it is hard to see how the world economy can really recover.